This blog covers financial, political and other topics the author gets the urge to write about. It does not provide personal financial, legal or other advice. Consider consulting a personal professional adviser before making any decisions. Copyright (c) 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017 by Leonard W. Wang. All rights reserved.

Tuesday, October 19, 2010

So What the Heck is China Up To?

The Chinese central bank raised interest rates today, signaling a slowdown in the growth of China's economy. Financial markets in the rest of the world took the news badly. The U.S. markets dropped 1.5 %.

China's government moved to cool down a blistering economy, driven by fear of inflation and a bubble in its real estate market. Must be tough to have such problems--economic growth that's too fast, rapidly rising asset values. Oddly perhaps, these problems stem from the U.S. Federal Reserve's easy money monetary policy. Because the Chinese yuan is tied to the dollar at a more or less fixed exchange rate, U.S. monetary policy flows through to China and becomes China's de facto monetary policy. The flood of liquidity from the Fed has had limited stimulative effect in America because of the slack in the U.S. economy. But China's economy is much more taut and easy money makes things happen in China.

Just as America's monetary policy becomes China's, so does China's monetary policy become America's. The dollar rose in the currency markets, and interest rates in the U.S. Treasuries market moved up, seemingly in sympathy with the Chinese move.

Logically, if the Chinese government wanted better control over the Chinese economy, it would de-link the yuan from the dollar and rid China of the Fed's easy money policies. Why hasn't it? With all the international outcry over the relatively weak yuan, the Chinese would garner brownie points with many other nations if they did so. And Chinese manufacturers could probably cover much or all of the cost increases resulting from a rising yuan by squeezing more productivity out of their facilities and employees. The Japanese faced the same challenge with a rising yen in the 1970s and 1980s. They quite successfully increased productivity and protected their export industries.

While the Chinese central bank, unlike the U.S. Fed, does not issue statements explaining its actions, a glance at the tea leaves suggests an explanation. China holds trillions of dollars of investments denominated in dollars--U.S. Treasuries, mortgage-backed investments and other paper. De-linking the yuan from the dollar, and the resulting fall in the dollar, could impose hundreds of billions of dollars of investment losses on the Chinese. Even though China is no longer expanding its dollar exposure, and instead buying Euro denominated investments, it remains stuck in a bear hug with the dollar and must protect the value of the dollar. By raising its own interest rates, it raises the value of the dollar, offsetting some of the dollar's recent weakness.

The underlying source of all this angst, sturm and drang is China's trade surplus. Whether denominated in dollars, Euros or whatever, China maintains a large and persistent trade surplus with the rest of the world. By all indications, it intends to maintain this trade surplus, even though Chinese leaders pay lip service to the notion of increasing domestic consumption. Much of the outside world perceives China's trade surplus as economic aggression, and reciprocates with disapproval, at a minimum. But China, the world's oldest continuous civilization, hasn't survived 4,000 years by poking everyone else in the eye with a sharp stick. So what the heck are they up to?

China has a severe demographic problem. It doesn't have enough young people to support all the older Chinese who will be retiring in the next few decades. With an already enormous population of 1.3 billion relying on its limited resources, China can't add enough young people, either through births or immigration, to satisfy its needs. By saving enormous amounts of money denominated in key foreign currencies like the dollar and Euro, China acquires the ability to purchase resources from other nations to support its old folks. It can draw on the productive capacity of younger people elsewhere in the world by purchasing the goods they produce. Without a large stash of foreign currency, however, China could have a difficult time supporting its retirees through imports. It would have to export Chinese goods in order to acquire the necessary foreign exchange, and its ability to do so ten, twenty, thirty or more years from now is unpredictable. By stashing away foreign currency now, while it has a trade advantage, it builds up a reservoir on which to draw later.

What does this mean for the future? That America will be closely connected to China for a long time, and very possibly on terms not highly favorable to America. But the good news is that eventually, when China needs to import goods to support its elderly, it will logically look to spend many of its dollars in the country that issues them.

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